Mortgage Sequence of Returns Risk Example.

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Watty
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Mortgage Sequence of Returns Risk Example.

Post by Watty »

On another thread about the "Should I pay off my mortgage?" question I posted a simplistic example of how the sequence of returns risk could impact you if you got unlucky and had a loss in your investments the first year while making a mortgage payment. I often post that example when people ask about about paying off their mortgage or not.

viewtopic.php?p=4731881#p4731881

Occasionally someone will question how valid my example is so I would like to get some more input about what people think and to see if there is an error in my reasoning, and if so to come up with a better simple example to explain the sequence of returns risk as it relates to paying off a mortgage or not.

Instead of hijacking that thread I am starting this new thread to discuss my example.

There is a wiki page on the sequence of returns risk and if there is a consensus about my example, or an improved version of it, then I may add a new example to that wiki page.

https://www.bogleheads.org/wiki/User:Le ... ed_example

Here is the relevant post from the prior thread;
EnjoyIt wrote: Tue Sep 03, 2019 8:51 am
Watty wrote: Tue Sep 03, 2019 8:29 am
EnjoyIt wrote: Tue Sep 03, 2019 8:18 am
Watty wrote: Tue Sep 03, 2019 7:15 am
 If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.
I keep seeing this thing above pop up and it is WRONG WRONG WRONG. The above assumes one will keep the $100k and pay off the mortgage from the earnings and not use up principal. This is not what any of the pay off mortgage threads talk about. I really wish people would stop posting this nonsense.
Could you give an example with some numbers to show how it is wrong?

If you have a mortage the money to make the monthly payment needs to come from somewhere. If you just pay it out of your paycheck then in this example that would be $500 a month that you would not be able depositing into your savings.
You are assuming the $100k has to stay at $100k at the end of the loan payment. This is not what is happening. The $100k is meant to go down to $0 or slightly above it in an ideal situation.

An example is a person has $100k loan at 3% over 30 years. Payments are $421.60 a month. If for this example the person has an account holding $100k which is invested in a 3% tax-free fund (I know it doesn't exist, just an example,) by the end of the 30 year term the fund will be worth $0 and the loan will be paid off. This is where you start your argument. If returns are lower than 3% over 30 years then this was a bad decision. If returns are higher than 3% over 30 years then this was a good decision. This person would not expect to still have the $100k left over as your example suggests.

I am pretty sure you and I have gone through this at least once before yet you still keep posting your example. Now if you really want to figure out sequence of return risk then instead of creating a straw man example, plug it into fircalc and see what comes up and what is the risk of running out of money before the 30 years is up. News flash in my hypothetical example the historical chance of coming back with less than started is 0%

EDIT: The results from FIRECalc on my hypothetical example is:
Here is how your portfolio would have fared in each of the 119 cycles. The lowest and highest portfolio balance at the end of your retirement was $100,000 to $905,355, with an average at the end of $478,683.
I know it is very simplistic and sort of "back of the envelope calculation". A few comments about it;

1) It does not take into account that you would also be paying down the home equity some.
2) It does not take taxes or inflation into account.
3) A 30 year $100K mortage at 4% would have a payment of $477 so the $500 payment figure it uses is a bit high.
4) To break even the second year you would not need to bring the portfolio all the way back to $100K since you would be paying down the loan. I check an amortization schedule and a 4% 30 year loan would have a remaining balance of $96,699 after two years.

This would all through the example off some but since it is only looking at a year or two I don't think that the difference would be enough a problem in an example that I tried to keep about a paragraph long.

On the response

1) The response makes a very valid point about how going down to a zero balance would be OK after 30 years, but my example was not for 30 years so that is a modest difference over 2 years.

2) I do not use Firecalc much but when I have I have noticed that it seems to have a bug in it when it says something like, "The lowest and highest portfolio balance at the end of your retirement was $100,000 to $905,355, ...." The $100K figure seems to be in error since it seems to just uses your beginning balance in some situations. I have noticed when I have used Firecalc before.

3) I just looked at 2 years in my example. The Firecalc example used 30 years which might apply to some people but few people actually keep a 30 year mortgage for the full 30 years. As I recall the average length of time for a 30 year mortgage is more like 7 to 10 years. It would be interesting to see what Firecalc(or one of the similar web sites) says if it was run for just 1, 2 or 7 years.


If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
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Re: Mortgage Sequence of Returns Risk Example.

Post by elainet7 »

in my mind additional principal payments monthly to knock down the mortgage is highly recommended
being debt free is emotionally liberating
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Re: Mortgage Sequence of Returns Risk Example.

Post by sergeant »

I agree with Enjoyit. Your example is faulty.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

sergeant wrote: Tue Sep 03, 2019 5:05 pm I agree with Enjoyit. Your example is faulty.
How would you suggest laying out a similar scenario, especially for a short time frame like the first two years?
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Re: Mortgage Sequence of Returns Risk Example.

Post by delamer »

Isn’t the danger in the sequence of returns risk to the long-term value of your portfolio?

If so, what is the point of looking at the portfolio value after just 2 years of returns and withdrawals?
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

Any type of fixed expense in retirement, by definition, increases sequence of returns risk because the expense must be paid even if the portfolio suffers. The greater the proportion of one's expenses, including a mortgage, that are fixed, the greater one's exposure to sequence of returns risk.

That being said, if one's total expenses, including both fixed and flexible expenses, are low enough, the actual impact of sequence of returns risk may be virtually zero.
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Re: Mortgage Sequence of Returns Risk Example.

Post by delamer »

willthrill81 wrote: Tue Sep 03, 2019 6:15 pm Any type of fixed expense in retirement, by definition, increases sequence of returns risk because the expense must be paid even if the portfolio suffers. The greater the proportion of one's expenses, including a mortgage, that are fixed, the greater one's exposure to sequence of returns risk.

That being said, if one's total expenses, including both fixed and flexible expenses, are low enough, the actual impact of sequence of returns risk may be virtually zero.
It also could be low or virtually zero if annuitized income covers most or all expenses.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

delamer wrote: Tue Sep 03, 2019 6:37 pm
willthrill81 wrote: Tue Sep 03, 2019 6:15 pm Any type of fixed expense in retirement, by definition, increases sequence of returns risk because the expense must be paid even if the portfolio suffers. The greater the proportion of one's expenses, including a mortgage, that are fixed, the greater one's exposure to sequence of returns risk.

That being said, if one's total expenses, including both fixed and flexible expenses, are low enough, the actual impact of sequence of returns risk may be virtually zero.
It also could be low or virtually zero if annuitized income covers most or all expenses.
Yes, since in that case, the withdrawals from one's portfolio would not be fixed.
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Re: Mortgage Sequence of Returns Risk Example.

Post by columbia »

delamer wrote: Tue Sep 03, 2019 6:37 pm
willthrill81 wrote: Tue Sep 03, 2019 6:15 pm Any type of fixed expense in retirement, by definition, increases sequence of returns risk because the expense must be paid even if the portfolio suffers. The greater the proportion of one's expenses, including a mortgage, that are fixed, the greater one's exposure to sequence of returns risk.

That being said, if one's total expenses, including both fixed and flexible expenses, are low enough, the actual impact of sequence of returns risk may be virtually zero.
It also could be low or virtually zero if annuitized income covers most or all expenses.
Which is why I plan to SPIA my way to meeting expected expenses and put the rest in Wellesley Income. My heirs can fight over the remainder. ;)
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Re: Mortgage Sequence of Returns Risk Example.

Post by randomguy »

willthrill81 wrote: Tue Sep 03, 2019 6:15 pm Any type of fixed expense in retirement, by definition, increases sequence of returns risk because the expense must be paid even if the portfolio suffers. The greater the proportion of one's expenses, including a mortgage, that are fixed, the greater one's exposure to sequence of returns risk.

That being said, if one's total expenses, including both fixed and flexible expenses, are low enough, the actual impact of sequence of returns risk may be virtually zero.
It should be pointed out that a mortgage isn't a fixed real expense. It is a fixed nominal one. It would be interesting to see how the 1966 retiree faired with a mortgage versus having more money in their portfolio. Taxes and the like can make doing the math pretty hard but I wouldn't be shocked to learn they did better. The 1929 retiree though I am betting was totally screwed....
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Re: Mortgage Sequence of Returns Risk Example.

Post by typical.investor »

Watty wrote: Tue Sep 03, 2019 2:58 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
So you are simply looking at withdrawals of $477 per month on a $100k portfolio over 30 years? At 0% inflation (because your $477 payment is fixed), I see a 90.2% probability of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

If you are hit by a sequence of bad returns at the beginning (worst two years of performance first), I see only a 54% chance of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

Unless I have made a mistake, it seems that a 4% mortgage would result in a 5.7% withdrawal rate and definitely be subject to sequence of return risk.
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Re: Mortgage Sequence of Returns Risk Example.

Post by grabiner »

If you have any bonds, you can avoid the sequence of returns risk by selling bonds to pay off the mortgage. If you have a bond portfolio which provides exactly enough money each year to make your mortgage payment, and you use it for that purpose (not counting it in your asset allocation), you are in the same position as if you had neither the bonds nor the mortgage: you have a mortgage and a "sinking fund" which makes the payments, and your portfolio risk comes from the rest of your investments.

This is why I count my mortgage as a negative bond in my asset allocation. If I pay off my mortgage by selling bonds (indirectly, by selling taxable stock and then moving an equal amount from bonds to stock in my retirement account), I will have the same number of dollars in stock. Thus, if the stock market crashes, I will have the same decline in my retirement funds whether I decide to keep my mortgage or pay it off next week. (With the recent decline in bond yields, I am seriously considering paying it off.)
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

Watty wrote: Tue Sep 03, 2019 2:58 pm On another thread about the "Should I pay off my mortgage?" question I posted a simplistic example of how the sequence of returns risk could impact you if you got unlucky and had a loss in your investments the first year while making a mortgage payment. I often post that example when people ask about about paying off their mortgage or not.

viewtopic.php?p=4731881#p4731881

Occasionally someone will question how valid my example is so I would like to get some more input about what people think and to see if there is an error in my reasoning, and if so to come up with a better simple example to explain the sequence of returns risk as it relates to paying off a mortgage or not.

Instead of hijacking that thread I am starting this new thread to discuss my example.

There is a wiki page on the sequence of returns risk and if there is a consensus about my example, or an improved version of it, then I may add a new example to that wiki page.

https://www.bogleheads.org/wiki/User:Le ... ed_example

Here is the relevant post from the prior thread;
EnjoyIt wrote: Tue Sep 03, 2019 8:51 am
Watty wrote: Tue Sep 03, 2019 8:29 am
EnjoyIt wrote: Tue Sep 03, 2019 8:18 am
Watty wrote: Tue Sep 03, 2019 7:15 am

I keep seeing this thing above pop up and it is WRONG WRONG WRONG. The above assumes one will keep the $100k and pay off the mortgage from the earnings and not use up principal. This is not what any of the pay off mortgage threads talk about. I really wish people would stop posting this nonsense.
Could you give an example with some numbers to show how it is wrong?

If you have a mortage the money to make the monthly payment needs to come from somewhere. If you just pay it out of your paycheck then in this example that would be $500 a month that you would not be able depositing into your savings.
You are assuming the $100k has to stay at $100k at the end of the loan payment. This is not what is happening. The $100k is meant to go down to $0 or slightly above it in an ideal situation.

An example is a person has $100k loan at 3% over 30 years. Payments are $421.60 a month. If for this example the person has an account holding $100k which is invested in a 3% tax-free fund (I know it doesn't exist, just an example,) by the end of the 30 year term the fund will be worth $0 and the loan will be paid off. This is where you start your argument. If returns are lower than 3% over 30 years then this was a bad decision. If returns are higher than 3% over 30 years then this was a good decision. This person would not expect to still have the $100k left over as your example suggests.

I am pretty sure you and I have gone through this at least once before yet you still keep posting your example. Now if you really want to figure out sequence of return risk then instead of creating a straw man example, plug it into fircalc and see what comes up and what is the risk of running out of money before the 30 years is up. News flash in my hypothetical example the historical chance of coming back with less than started is 0%

EDIT: The results from FIRECalc on my hypothetical example is:
Here is how your portfolio would have fared in each of the 119 cycles. The lowest and highest portfolio balance at the end of your retirement was $100,000 to $905,355, with an average at the end of $478,683.
I know it is very simplistic and sort of "back of the envelope calculation". A few comments about it;

1) It does not take into account that you would also be paying down the home equity some.
2) It does not take taxes or inflation into account.
3) A 30 year $100K mortage at 4% would have a payment of $477 so the $500 payment figure it uses is a bit high.
4) To break even the second year you would not need to bring the portfolio all the way back to $100K since you would be paying down the loan. I check an amortization schedule and a 4% 30 year loan would have a remaining balance of $96,699 after two years.

This would all through the example off some but since it is only looking at a year or two I don't think that the difference would be enough a problem in an example that I tried to keep about a paragraph long.

On the response

1) The response makes a very valid point about how going down to a zero balance would be OK after 30 years, but my example was not for 30 years so that is a modest difference over 2 years.

2) I do not use Firecalc much but when I have I have noticed that it seems to have a bug in it when it says something like, "The lowest and highest portfolio balance at the end of your retirement was $100,000 to $905,355, ...." The $100K figure seems to be in error since it seems to just uses your beginning balance in some situations. I have noticed when I have used Firecalc before.

3) I just looked at 2 years in my example. The Firecalc example used 30 years which might apply to some people but few people actually keep a 30 year mortgage for the full 30 years. As I recall the average length of time for a 30 year mortgage is more like 7 to 10 years. It would be interesting to see what Firecalc(or one of the similar web sites) says if it was run for just 1, 2 or 7 years.


If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
My example was flawed. I accidentally imputed a monthly payment for the whole year. Which means the yearly expense was 1/12 of what it should be. The results I got from Cfiresim showed only two years that my example failed in history 1929 and 1930. I think those are pretty good odds for keeping a 3% mortgage as in my example.

My advise is use Cfiresim instead of Firecal. Use the monthly payment and multiply it by 12 (which I forgot to do.) And most importantly do not adjust payment to inflation as one would if they were using the calculator for retirement. Inflation benefits the mortgage holder.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

typical.investor wrote: Tue Sep 03, 2019 7:35 pm
Watty wrote: Tue Sep 03, 2019 2:58 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
So you are simply looking at withdrawals of $477 per month on a $100k portfolio over 30 years? At 0% inflation (because your $477 payment is fixed), I see a 90.2% probability of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

If you are hit by a sequence of bad returns at the beginning (worst two years of performance first), I see only a 54% chance of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

Unless I have made a mistake, it seems that a 4% mortgage would result in a 5.7% withdrawal rate and definitely be subject to sequence of return risk.
I am curious. Did you accidentally adjust the withdrawal to inflation or keep the withdrawal as a fixed payment which it should be?) Although originally you start with a 5.7% withdrawal, the mortgage is ravaged by decades of inflation making the payment effectively smaller and smaller
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

EnjoyIt wrote: Tue Sep 03, 2019 10:27 pm
typical.investor wrote: Tue Sep 03, 2019 7:35 pm
Watty wrote: Tue Sep 03, 2019 2:58 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
So you are simply looking at withdrawals of $477 per month on a $100k portfolio over 30 years? At 0% inflation (because your $477 payment is fixed), I see a 90.2% probability of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

If you are hit by a sequence of bad returns at the beginning (worst two years of performance first), I see only a 54% chance of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

Unless I have made a mistake, it seems that a 4% mortgage would result in a 5.7% withdrawal rate and definitely be subject to sequence of return risk.
I am curious. Did you accidentally adjust the withdrawal to inflation or keep the withdrawal as a fixed payment which it should be?) Although originally you start with a 5.7% withdrawal, the mortgage is ravaged by decades of inflation making the payment effectively smaller and smaller
Yes, that was with no inflation.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Big Dog »

If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
Then, instead of putting the $100k into an equity account, put it into a ST bond fund (duration of ~2 years). That way your time frames are consistent; otherwise, you are comparing LT and ST in the same example. Of course, a ST bond fund eliminates your SoR argument.

(Indeed, that is exactly what I have done. I have $150k left on my mortgage and have about that much in cash/medium term bonds to cover it should I ever get the itch to pay it off.)
Last edited by Big Dog on Tue Sep 03, 2019 11:12 pm, edited 1 time in total.
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Re: Mortgage Sequence of Returns Risk Example.

Post by typical.investor »

EnjoyIt wrote: Tue Sep 03, 2019 10:27 pm
I am curious. Did you accidentally adjust the withdrawal to inflation or keep the withdrawal as a fixed payment which it should be?) Although originally you start with a 5.7% withdrawal, the mortgage is ravaged by decades of inflation making the payment effectively smaller and smaller

Anyway, you are simply ignoring sequence of return risk.

If year one the withdrawal rate is 5.7%, and the portfolio suffers a 40% loss, is your withdrawal rate in year two effectively small due to inflation as you claim. I think year two your withdrawal rate would be closer to 9.5%. But you are thinking it would be less than 5.7%.
Last edited by typical.investor on Tue Sep 03, 2019 11:30 pm, edited 1 time in total.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

Big Dog wrote: Tue Sep 03, 2019 11:08 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
Then, instead of putting the $100k into an equity account, put it into a ST bond fund (duration of ~2 years). That way your time frames are consistent; otherwise, you are comparing LT and ST in the same example. Of course, a ST bond fund eliminates your SoR argument.
The problem with bonds is that the expected return of bonds is lower than the mortgage rate. Borrowing money at 4% only to lend it out at 2% might make some sense when someone needs liquidity, but a retiree with a good portfolio should have no such need. Yes, there is less sequence of returns risk with bonds, but if there is negative arbitrage taking place, you'd be far better off just to pay off the mortgage.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Big Dog »

^^sry, I did not see in the OP that the intent was to arbitrage the rates.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

Big Dog wrote: Tue Sep 03, 2019 11:17 pm ^^sry, I did not see in the OP that the intent was to arbitrage the rates.
If you can't, then there's likely little reason to retain the mortgage apart from potential taxes on the portfolio withdrawals.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Big Dog »

additional liquidity is a good reason for most. (perhaps not Bogleheads, but for the masses.)
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

I will try to look at the detail of the posts tomorrow when I have more time.

One thing that would be interesting to look at in the investing simulators is how the portfolio would do after shorter time periods like 2 or maybe 7 years.

I did not crunch the numbers yet I would expect the sequence of returns risk to matter less if you held the mortage for 30 years since there would be more time for a portfolio to recover after a bad initial start.

To me the big question is how often the portfolio would be a lot lower than the mortage payoff amount a couple of years into a 30 year mortage.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

Watty wrote: Tue Sep 03, 2019 11:21 pmI did not crunch the numbers yet I would expect the sequence of returns risk to matter less if you held the mortage for 30 years since there would be more time for a portfolio to recover after a bad initial start.
Sequence of returns risk would still be an issue there. The only way that it wouldn't be is if the mortgage can be paid for apart from portfolio withdrawals.

Year 2000 retirees who withdrew a nominal $477 monthly from a $100k starting balance invested in all TSM would now have only $5,038 left, fewer than 11 months of mortgage payments left. And it would actually have been even worse because 30 year mortgage rates were around 8% back in 2000.
Last edited by willthrill81 on Tue Sep 03, 2019 11:28 pm, edited 1 time in total.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

typical.investor wrote: Tue Sep 03, 2019 11:10 pm
EnjoyIt wrote: Tue Sep 03, 2019 10:27 pm
typical.investor wrote: Tue Sep 03, 2019 7:35 pm
Watty wrote: Tue Sep 03, 2019 2:58 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
So you are simply looking at withdrawals of $477 per month on a $100k portfolio over 30 years? At 0% inflation (because your $477 payment is fixed), I see a 90.2% probability of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

If you are hit by a sequence of bad returns at the beginning (worst two years of performance first), I see only a 54% chance of success.

https://www.portfoliovisualizer.com/mon ... unt=100000

Unless I have made a mistake, it seems that a 4% mortgage would result in a 5.7% withdrawal rate and definitely be subject to sequence of return risk.
I am curious. Did you accidentally adjust the withdrawal to inflation or keep the withdrawal as a fixed payment which it should be?) Although originally you start with a 5.7% withdrawal, the mortgage is ravaged by decades of inflation making the payment effectively smaller and smaller
Is not mortgage payment not $477/month until it is paid off? It's a fixed amount correct?

My understanding that adding in inflation will result in quicker depletion of the portfolio because the $477 spending will become over $1000 in 30 years at 3% inflation, but the portfolio return are not changed.

Try it. Put in a $0 withdrawal and use historical inflation. Then use zero inflation. Then use 99% inflation. Your final portfolio value isn't changing. All you are changing is how much will be withdrawn from the portfolio each year. Of course, at $0 withdraw it makes no difference, but put in the $477/month and adjust inflation. You will see that higher inflation means the spend down is quicker as it adjust the withdrawal to maintain a constant value.

As you say though, the mortgage payment is fixed and needs no inflation adjustment.

My conclusion remains the same. Sequence of return risk is real when investing $100000 and trying to use it to pay off a mortgage at 3% (at $477/month).
I think you misunderstood the point of my question. I just wanted to make sure you did not allow the $477 to increase with inflation as would occur in most retirement calculators. Inflation must be kept at 0% as you said the payment is fixed and does not change every year.

I am not arguing with your statement "Sequence of return risk is real." Which is why I would never recommend holding a mortgage in retirement as one would like to minimize SOR. But, when one is in the accumulation phase of their life, taking on the small risk is one worth taking.

My argument was/is with the OP example and why it is the wrong way to look at SOR. It makes it appear much worse than it really is.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

EnjoyIt wrote: Tue Sep 03, 2019 11:26 pm My argument was/is with the OP example and why it is the wrong way to look at SOR. It makes it appear much worse than it really is.
I think that the graph below demonstrates with real world data how bad it could be, and it could obviously be much worse than even this.

These hypothetical retirees will come up almost a decade short of paying off their mortgage. They definitely lost out to sequence of returns risk in a big way.

Image
$100k starting balance, $477 nominal withdrawn monthly, 100% TSM
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
typical.investor
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Re: Mortgage Sequence of Returns Risk Example.

Post by typical.investor »

EnjoyIt wrote: Tue Sep 03, 2019 11:26 pm I am not arguing with your statement "Sequence of return risk is real." Which is why I would never recommend holding a mortgage in retirement as one would like to minimize SOR. But, when one is in the accumulation phase of their life, taking on the small risk is one worth taking.
What's the relevance of retirement?

If you have $100k at age 35 and invest it instead of paying your mortgage, and that plan is in the 46% of cases that fail when your returns from age 35-37 are awful, then you start retirement with an unpaid mortgage.

How is that not a risk?

OK you have from age 38 to 65 to save more, but you wouldn't have had to do that if you had just paid off the mortgage.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

Watty wrote: Tue Sep 03, 2019 11:21 pm I will try to look at the detail of the posts tomorrow when I have more time.

One thing that would be interesting to look at in the investing simulators is how the portfolio would do after shorter time periods like 2 or maybe 7 years.

I did not crunch the numbers yet I would expect the sequence of returns risk to matter less if you held the mortage for 30 years since there would be more time for a portfolio to recover after a bad initial start.

To me the big question is how often the portfolio would be a lot lower than the mortage payoff amount a couple of years into a 30 year mortage.
My investments are here not for just a few years, but for the next 40+ years (I hope.) It matters not what happens tomorrow but what happens over the next several decades. If I was to retire tomorrow, sure I worry about the next couple of years (SOR.) But if my goal is to build wealth with many years to go and I have a low interest rate mortgage, I would not be too eager in paying it off. I must add, that is me and my risk tolerance. Others would rather pay off that debt because they can not stomach the risk. I get it. Others may pay off the loan because the small arbitrage of investing vs mortgage payment is just not worth it to them. They are wealthy enough to make the decision to eliminate the debt. I get that as well.

Another way to answer your question, is that if you have an expense that needs to be payed in <5 years, then that money should be saved in a high yield savings account, money market fund, or maybe short term treasuries. This is not money you should be risking in equities.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

typical.investor wrote: Tue Sep 03, 2019 11:38 pm
EnjoyIt wrote: Tue Sep 03, 2019 11:26 pm I am not arguing with your statement "Sequence of return risk is real." Which is why I would never recommend holding a mortgage in retirement as one would like to minimize SOR. But, when one is in the accumulation phase of their life, taking on the small risk is one worth taking.
What's the relevance of retirement?

If you have $100k at age 35 and invest it instead of paying your mortgage, and that plan is in the 46% of cases that fail when your returns from age 35-37 are awful, then you start retirement with an unpaid mortgage.

How is that not a risk?

OK you have from age 38 to 65 to save more, but you wouldn't have had to do that if you had just paid off the mortgage.
Your % of failure is too high. IN addition, we are talking about people in the accumulation phase and not the retirement phase or close to it. Someone in retirement has less ability to take on risk compared to a 30 year old in the early parts of their career. If someone offered me a bet that is within my means to make where the odds of winning is 75%, I would take that bet each and every time. Each and every time. This is even more so when the degree of failure may only be a small amount.

I did the historical math for my own mortgage. I had a few instances where I dropped below $0 by a small amount. I had 2 instances where the drop was significant and that was in 1929 and 1930. I had a few instances where I was slightly ahead, and a very large amount of instances where I was up significantly.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

willthrill81 wrote: Tue Sep 03, 2019 11:32 pm
EnjoyIt wrote: Tue Sep 03, 2019 11:26 pm My argument was/is with the OP example and why it is the wrong way to look at SOR. It makes it appear much worse than it really is.
I think that the graph below demonstrates with real world data how bad it could be, and it could obviously be much worse than even this.

These hypothetical retirees will come up almost a decade short of paying off their mortgage. They definitely lost out to sequence of returns risk in a big way.

Image
$100k starting balance, $477 nominal withdrawn monthly, 100% TSM
I'm not sure what you are trying to prove. I agree with you. In retirement not having debt decreases SOR. We are talking about people in the accumulation phase of their life, where the ability to take on some risk is far greater.
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Steve Reading
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Re: Mortgage Sequence of Returns Risk Example.

Post by Steve Reading »

As an accumulator, keeping the mortgage will generally decrease your sequence of return risk by letting you hit your lifetime stock allocation targets sooner.

Proof by contradiction:
If you do pay off the mortgage, that year's stock return will have a smaller effect on your wealth since you'll have less invested. The following year will have a bigger effect since you'll have more money invested (accumulation). This creates a sequence of return risk that wouldn't occur if you keep the mortgage that first year, and prepay the next.

In other words, those starting to accumulate expose themselves to the most amount of SOR risk. By paying off the mortgage, you "reset" back to an earlier state of accumulation.

It is the opposite for retirement.

Hence you can make the generalization that minimizing SOR is done by mortgaging your retirement to the extent possible; borrow heavily (and keeping the debt when accumulating) and paying that debt down aggressively later when closer to or at retirement.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Mortgage Sequence of Returns Risk Example.

Post by typical.investor »

305pelusa wrote: Wed Sep 04, 2019 8:18 am As an accumulator, keeping the mortgage will generally decrease your sequence of return risk by letting you hit your lifetime stock allocation targets sooner.

Proof by contradiction:
If you do pay off the mortgage, that year's stock return will have a smaller effect on your wealth since you'll have less invested. The following year will have a bigger effect since you'll have more money invested (accumulation). This creates a sequence of return risk that wouldn't occur if you keep the mortgage that first year, and prepay the next.

In other words, those starting to accumulate expose themselves to the most amount of SOR risk. By paying off the mortgage, you "reset" back to an earlier state of accumulation.

It is the opposite for retirement.

Hence you can make the generalization that minimizing SOR is done by mortgaging your retirement to the extent possible; borrow heavily (and keeping the debt when accumulating) and paying that debt down aggressively later when closer to or at retirement.
My understanding is that what causes the SOR risk is the need to spend after a crash, and having to make those payments by selling depreciated assets. That's why having a monthly $477 payment could be a risk.

If you pay off the mortgage, you don't face SOR with the mortgage amount anyway.

But yeah, more leverage will always work better until it doesn't.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Steve Reading »

typical.investor wrote: Wed Sep 04, 2019 8:36 am
305pelusa wrote: Wed Sep 04, 2019 8:18 am As an accumulator, keeping the mortgage will generally decrease your sequence of return risk by letting you hit your lifetime stock allocation targets sooner.

Proof by contradiction:
If you do pay off the mortgage, that year's stock return will have a smaller effect on your wealth since you'll have less invested. The following year will have a bigger effect since you'll have more money invested (accumulation). This creates a sequence of return risk that wouldn't occur if you keep the mortgage that first year, and prepay the next.

In other words, those starting to accumulate expose themselves to the most amount of SOR risk. By paying off the mortgage, you "reset" back to an earlier state of accumulation.

It is the opposite for retirement.

Hence you can make the generalization that minimizing SOR is done by mortgaging your retirement to the extent possible; borrow heavily (and keeping the debt when accumulating) and paying that debt down aggressively later when closer to or at retirement.
My understanding is that what causes the SOR risk is the need to spend after a crash, and having to make those payments by selling depreciated assets. That's why having a monthly $477 payment could be a risk.

If you pay off the mortgage, you don't face SOR with the mortgage amount anyway.

But yeah, more leverage will always work better until it doesn't.
You're right that having expenses (funds flowing out of portfolio) increases SOR. Conversely, I hope you appreciate that funds flowing IN do so as well. In the former, you could spend right after a crash. In the latter, you'd buy right after a rally. They're mirror situations.

The accumulator, by definition, has a positive inflow of funds. So any debt that creates offsetting negative outflows (like a mortgage) decreases your SOR.

If you could borrow your entire retirement such that every future savings goes to service the debt (no net inflows or outflows), you'd have zero SOR risk. Of course that's not realistic but to the extent you can do so, you'd decrease the SOR risk
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

EnjoyIt wrote: Tue Sep 03, 2019 11:58 pm
willthrill81 wrote: Tue Sep 03, 2019 11:32 pm
EnjoyIt wrote: Tue Sep 03, 2019 11:26 pm My argument was/is with the OP example and why it is the wrong way to look at SOR. It makes it appear much worse than it really is.
I think that the graph below demonstrates with real world data how bad it could be, and it could obviously be much worse than even this.

These hypothetical retirees will come up almost a decade short of paying off their mortgage. They definitely lost out to sequence of returns risk in a big way.

Image
$100k starting balance, $477 nominal withdrawn monthly, 100% TSM
I'm not sure what you are trying to prove. I agree with you. In retirement not having debt decreases SOR. We are talking about people in the accumulation phase of their life, where the ability to take on some risk is far greater.
I agree that SRR is less of a problem in the accumulation phase. And 305pelusa is correct that paying off a mortgage early increases one's sequence of returns risk because it results in a lower stock allocation in one's younger years and higher in one's older years.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

I had chance to play with the numbers some, but this just a basic run that could be expanded on.

The question I ended up looking at was;

If you have a 30 years mortgage at 4% for $100K and you invest $100K in a separate portfolio that you make the payments from, then at the end of five years will you have enough to pay off the mortgage?

Here are the base numbers.

Loan amount: $100,000

Monthly payment a 4%: Month: 477.42 Year: 5729.04

Payoff amount in five year: 90,447.51

No inflation adjustment.

I ran into a couple of limitations which were;

1) What asset allocation to use? With the historical data there were a lot of years when interest rates were really high and even in double digits. I did not think it would be fair to use those so I used 100% stocks which may not be realistic.

2) I wanted to also look at one and two years but Portfolio Visualizer would not let me look at less than five years.

Here is a link to the model that I set up.

https://www.portfoliovisualizer.com/mon ... unt=100000

The most important result was;

Portfolio End Balance (nominal)
1 Percentile $36,835 (*)
5 Percentile $55,464 (*)
10th Percentile $69,257
22th Percentile $89,081 (*)
25th Percentile $94,911
50th Percentile $130,368
75th Percentile $170,956
90th Percentile $210,685
95th Percentile $234,174 (*)
99th Percentile $280,142 (*)

(*) = created on separate runs.

At the end of the five years the mortgage payoff amount would be 90,447.51, so in a bit more than 22% of the cases there would not be enough in the portfolio to pay off the mortgage.

Conclusion

I am still pondering what this means. The positive results above 90% were higher than I would have expected but that in part might be related to using 100% stocks and not taking taxes into account but the amounts are still impressive if they are correct.

Looking at the 50th percentile $130,368 when the payoff amount is $90,447.51 gives a median gain of a bit less than $40K, but again that is with 100% stock and without taxes.

Maybe one way of looking at it is that for at least for the first five years keeping the mortgage is a bet that could pay off well but that will not turn out well about 22% of the time.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

I have been looking at a way to expand my example. Here is a possible update.
 If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To pay off the mortage at the end of the second year you would need about $96.5K so you would need to gain back $12.5K To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which combined is $22K. $18.5K. That would take a 25.6% 22% return on the remaining $84K just to break even. to get back to the point where you could pay off the mortage.

In the past portfolios have declined in roughly one of four or five years depending on the asset allocation. (20 to 25 percent of the time)

https://www.vanguard.com/us/insights/sa ... llocations

The sequence of returns risk can also go the other way and you could get lucky and have the first couple of years get good returns that would put you on the path for large gains over the years. There will sometimes be very optimistic projections on just how much better not paying off the mortgage could be but one limiting factor that needs to be considered is that few people actually keep a 30 year mortgage for the full 30 years. It is difficult to put a number on it but many people who own a home will sell it in less than 10 years.

Any suggestions on how to improve this?
Last edited by Watty on Fri Sep 06, 2019 6:08 am, edited 2 times in total.
EnjoyIt
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

Watty wrote: Thu Sep 05, 2019 9:29 pm I have been looking at a way to expand my example. Here is a possible update.
 If you do not pay it off then you will have more sequence of returns risk. For example in rough numbers if you just kept a $100K mortgage and also put $100K into a separate investing account which you also pay a $500 a month mortgage out of then;

a) If you get unlucky and get a modest 10% decline in the portfolio the first year then it would be down to $90K
b) You would also need to pay the $500 a month mortgage($6,000) so your portfolio would be down to $84K
c) To break even the next year you would need to gain back the $16K and another $6,000 for the next years mortgage payments which is $22K. That would take a 25.6% return on the remaining $84K just to break even.

In the past portfolios have declined in roughly one of four or five years depending on the asset allocation. (20 to 25 percent of the time)

https://www.vanguard.com/us/insights/sa ... llocations

The sequence of returns risk can also go the other way and you could get lucky and have the first couple of years get good returns that would put you on the path for large gains over the years. There will sometimes be very optimistic projections on just how much better not paying off the mortgage could be but one limiting factor that needs to be considered is that few people actually keep a 30 year mortgage for the full 30 years. It is difficult to put a number on it but many people who own a home will sell it in less than 10 years.

Any suggestions on how to improve this?
Yes, you still expect the portfolio to be worth $100k at the end of every year. That is just as wrong as the day we started this conversation.

Instead of fearmongering with factitious data, show real examples based on historic returns as described in the posts above.

Also, creating an example that only lasts two years is also a mistake because we Bogleheads recommend people to not invest any money that is needed within two years. We invest for decades, and not a two year holding period.

I’m really not quite sure why you are trying to create something out of nothing. Just accept that in the accumulation phase holding unto a mortgage and investing has very good odds of improving the financial outlook of the investor and the mortgage decreases sequence of return risk. On the contrary, in retirement being debt free decreases sequence of return risk.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Yes, you still expect the portfolio to be worth $100k at the end of every year. That is just as wrong as the day we started this conversation.
Thanks for catching that. I was so focused on the other details that I forgot to redo my numbers for that part of the example. I have edited the example above in blue to reflect that.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Instead of fearmongering with factitious data, show real examples based on historic returns as described in the posts above.
I don't feel real confident about how well it models the past but I did try to use Portfolio Visualizer in my prior post to try to see how a five year model might work.

The post by willthrill81 also gave an excellent example of how a investing the money would have worked out if you were starting in 2000.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Also, creating an example that only lasts two years is also a mistake because we Bogleheads recommend people to not invest any money that is needed within two years. We invest for decades, and not a two year holding period.
My main point was that if you got unlucky you could get off to a bad start and I was trying to make that point in a statement that is only a paragraph or so long.

I agree that using a mortage for leverage will have an overall better result on average but some percentage of the time it will work out badly so I was trying to show how that might happen.

Could you suggest an example that you think works better?
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm I’m really not quite sure why you are trying to create something out of nothing. Just accept that in the accumulation phase holding unto a mortgage and investing has very good odds of improving the financial outlook of the investor and the mortgage decreases sequence of return risk. On the contrary, in retirement being debt free decreases sequence of return risk.
I would agree that in the accumulation phase you may be able to save more to be able to overcome some bad investing years like in my example but that does not in any way decrease the sequence of returns risk.

A bad analogy would be that if you are young and go skateboarding and break an arm then you can just get a cast and it will likely heal OK. Being able to recover OK does not mean that there was not risk.

Maybe one way of looking at it may that the potential payoff from keeping a mortage while investing the money is large enough that it is a good bet, but it is still a bet that the sequence of returns risk will cause you to lose some percentage of the time.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Steve Reading »

Watty wrote: Fri Sep 06, 2019 6:06 am
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Yes, you still expect the portfolio to be worth $100k at the end of every year. That is just as wrong as the day we started this conversation.
Thanks for catching that. I was so focused on the other details that I forgot to redo my numbers for that part of the example. I have edited the example above in blue to reflect that.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Instead of fearmongering with factitious data, show real examples based on historic returns as described in the posts above.
I don't feel real confident about how well it models the past but I did try to use Portfolio Visualizer in my prior post to try to see how a five year model might work.

The post by willthrill81 also gave an excellent example of how a investing the money would have worked out if you were starting in 2000.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Also, creating an example that only lasts two years is also a mistake because we Bogleheads recommend people to not invest any money that is needed within two years. We invest for decades, and not a two year holding period.
My main point was that if you got unlucky you could get off to a bad start and I was trying to make that point in a statement that is only a paragraph or so long.

I agree that using a mortage for leverage will have an overall better result on average but some percentage of the time it will work out badly so I was trying to show how that might happen.

Could you suggest an example that you think works better?
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm I’m really not quite sure why you are trying to create something out of nothing. Just accept that in the accumulation phase holding unto a mortgage and investing has very good odds of improving the financial outlook of the investor and the mortgage decreases sequence of return risk. On the contrary, in retirement being debt free decreases sequence of return risk.
I would agree that in the accumulation phase you may be able to save more to be able to overcome some bad investing years like in my example but that does not in any way decrease the sequence of returns risk.

A bad analogy would be that if you are young and go skateboarding and break an arm then you can just get a cast and it will likely heal OK. Being able to recover OK does not mean that there was not risk.

Maybe one way of looking at it may that the potential payoff from keeping a mortage while investing the money is large enough that it is a good bet, but it is still a bet that the sequence of returns risk will cause you to lose some percentage of the time.
Watty, would you say there is a sequence of returns risk when you save money via DCA?
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

305pelusa wrote: Fri Sep 06, 2019 6:46 am Watty, would you say there is a sequence of returns risk when you save money via DCA?
That is a different situation but yes.

For example if you save $1,000 a year for 10 years and get but then there is one bad year the last year and your investments drop by 30% then you will be hurt more than if the one bad year was the first year.

The opposite would be if you had $10,000 that you invested all at once and knew that you would keep it invested for 10 years then it would not matter if the one bad year was the first or last year.
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Re: Mortgage Sequence of Returns Risk Example.

Post by Steve Reading »

Watty wrote: Fri Sep 06, 2019 7:01 am
305pelusa wrote: Fri Sep 06, 2019 6:46 am Watty, would you say there is a sequence of returns risk when you save money via DCA?
That is a different situation but yes.

For example if you save $1,000 a year for 10 years and get but then there is one bad year the last year and your investments drop by 30% then you will be hurt more than if the one bad year was the first year.

The opposite would be if you had $10,000 that you invested all at once and knew that you would keep it invested for 10 years then it would not matter if the one bad year was the first or last year.
Yes I agree. So let's take that example to it's logical conclusion.

So now imagine you have 10k left in your mortgage, 10k invested in stocks, save 1k a year and have 10 years until retirement.

If you pay the mortgage off, you'll end up in the exact same situation as your first scenario. There is sequence of return risk.

If you instead keep the 10k invested and use all of your future savings to pay down the mortgage, it is like being in your second scenario. There's no sequence of return risk any more.
"... so high a present discounted value of wealth, it is only prudent for him to put more into common stocks compared to his present tangible wealth, borrowing if necessary" - Paul Samuelson
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

Watty wrote: Fri Sep 06, 2019 6:06 am
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Yes, you still expect the portfolio to be worth $100k at the end of every year. That is just as wrong as the day we started this conversation.
Thanks for catching that. I was so focused on the other details that I forgot to redo my numbers for that part of the example. I have edited the example above in blue to reflect that.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Instead of fearmongering with factitious data, show real examples based on historic returns as described in the posts above.
I don't feel real confident about how well it models the past but I did try to use Portfolio Visualizer in my prior post to try to see how a five year model might work.

The post by willthrill81 also gave an excellent example of how a investing the money would have worked out if you were starting in 2000.
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm Also, creating an example that only lasts two years is also a mistake because we Bogleheads recommend people to not invest any money that is needed within two years. We invest for decades, and not a two year holding period.
My main point was that if you got unlucky you could get off to a bad start and I was trying to make that point in a statement that is only a paragraph or so long.

I agree that using a mortage for leverage will have an overall better result on average but some percentage of the time it will work out badly so I was trying to show how that might happen.

Could you suggest an example that you think works better?
EnjoyIt wrote: Thu Sep 05, 2019 9:39 pm I’m really not quite sure why you are trying to create something out of nothing. Just accept that in the accumulation phase holding unto a mortgage and investing has very good odds of improving the financial outlook of the investor and the mortgage decreases sequence of return risk. On the contrary, in retirement being debt free decreases sequence of return risk.
I would agree that in the accumulation phase you may be able to save more to be able to overcome some bad investing years like in my example but that does not in any way decrease the sequence of returns risk.

A bad analogy would be that if you are young and go skateboarding and break an arm then you can just get a cast and it will likely heal OK. Being able to recover OK does not mean that there was not risk.

Maybe one way of looking at it may that the potential payoff from keeping a mortage while investing the money is large enough that it is a good bet, but it is still a bet that the sequence of returns risk will cause you to lose some percentage of the time.
Even 5 years is not a long enough time frame. Again, we invest for the decades not for 5 years.
Also, by ignoring the sequence of return risk reduction by having cash vs a lower mortgage you ignore a very important aspect in the calculation. If I was to have $100k with a $100k mortgage I would fare much better in a recession and job loss as compared to $0 money and no mortgage. Cash is a very big deal. Even if a 70/30 portfolio dropped by 50% I would still be better off becuase I actually have money to eat. This is exacerbated even further if the mortgage is only partially paid off and I still need to make payments. You just can’t ignore this part of the calculation if you are discussing risk.

The reason why no one has given you a simple example as you desire is because it is not simple. There are multiple moving parts. There is the mortgage, there is inflation, there is dollar cost averaging (sort of,) there is market return, there is sequence of return risk reduction. There are also pay raises that can occur. Honestly, anything that you come up with that ignores the entire picture is fearmongering. I don’t know, maybe this reflects your choices and everything turned out well for you, but this is not a wise decision for the majority of accumulators out there.

If you extract your $100k example out over 50 years which can very well be the timeframe for such a decision there is a more than 25% chance to be far far ahead by 100s of thousands of dollars based on historical data.
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Re: Mortgage Sequence of Returns Risk Example.

Post by willthrill81 »

305pelusa wrote: Fri Sep 06, 2019 6:46 am Watty, would you say there is a sequence of returns risk when you save money via DCA?
DCA does not eliminate sequence of returns risk (SRR); it only minimizes it.

For instance, even if an investor saved the same real dollars every week, month, etc. for decades, the last decade or so of accumulation is most important to them in terms of returns simply because they have more accumulated then than in prior decades. That's why some have referred to the decade before retirement and the decade after retirement as the 'red zone'.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
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Re: Mortgage Sequence of Returns Risk Example.

Post by Watty »

EnjoyIt wrote: Fri Sep 06, 2019 8:49 am Even 5 years is not a long enough time frame. Again, we invest for the decades not for 5 years.
Also, by ignoring the sequence of return risk reduction by having cash vs a lower mortgage you ignore a very important aspect in the calculation. If I was to have $100k with a $100k mortgage I would fare much better in a recession and job loss as compared to $0 money and no mortgage. Cash is a very big deal. Even if a 70/30 portfolio dropped by 50% I would still be better off becuase I actually have money to eat. This is exacerbated even further if the mortgage is only partially paid off and I still need to make payments. You just can’t ignore this part of the calculation if you are discussing risk.

The reason why no one has given you a simple example as you desire is because it is not simple. There are multiple moving parts. There is the mortgage, there is inflation, there is dollar cost averaging (sort of,) there is market return, there is sequence of return risk reduction. There are also pay raises that can occur. Honestly, anything that you come up with that ignores the entire picture is fearmongering. I don’t know, maybe this reflects your choices and everything turned out well for you, but this is not a wise decision for the majority of accumulators out there.

If you extract your $100k example out over 50 years which can very well be the timeframe for such a decision there is a more than 25% chance to be far far ahead by 100s of thousands of dollars based on historical data.
I totally agree that there are lots of other factors that are involved in deciding to pay off a mortage or not.
The long term expectations are also important.

That does not make the expectations of how the choice might perform over time shorter time frames unimportant. There are lots reasons that people end up selling houses before they have owned them for even ten years.
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Re: Mortgage Sequence of Returns Risk Example.

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Big Dog wrote: Tue Sep 03, 2019 11:08 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
Then, instead of putting the $100k into an equity account, put it into a ST bond fund (duration of ~2 years). That way your time frames are consistent; otherwise, you are comparing LT and ST in the same example. Of course, a ST bond fund eliminates your SoR argument.

(Indeed, that is exactly what I have done. I have $150k left on my mortgage and have about that much in cash/medium term bonds to cover it should I ever get the itch to pay it off.)
With yields as low as they are on ST and IT bond funds is it worthwhile keeping the mortgage?
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Re: Mortgage Sequence of Returns Risk Example.

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catalina355 wrote: Fri Sep 06, 2019 2:57 pm
Big Dog wrote: Tue Sep 03, 2019 11:08 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
Then, instead of putting the $100k into an equity account, put it into a ST bond fund (duration of ~2 years). That way your time frames are consistent; otherwise, you are comparing LT and ST in the same example. Of course, a ST bond fund eliminates your SoR argument.

(Indeed, that is exactly what I have done. I have $150k left on my mortgage and have about that much in cash/medium term bonds to cover it should I ever get the itch to pay it off.)
With yields as low as they are on ST and IT bond funds is it worthwhile keeping the mortgage?
About the only logical reason, IMHO, to keep the mortgage is if one places a higher value on keeping one's assets liquid than the after-tax interest rate/yield difference.
“It's a dangerous business, Frodo, going out your door. You step onto the road, and if you don't keep your feet, there's no knowing where you might be swept off to.” J.R.R. Tolkien,The Lord of the Rings
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Re: Mortgage Sequence of Returns Risk Example.

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catalina355 wrote: Fri Sep 06, 2019 2:57 pm
Big Dog wrote: Tue Sep 03, 2019 11:08 pm
If anyone can see a way to improve my example, focusing on the first year or two, I would sure like to hear any suggestions.
Then, instead of putting the $100k into an equity account, put it into a ST bond fund (duration of ~2 years). That way your time frames are consistent; otherwise, you are comparing LT and ST in the same example. Of course, a ST bond fund eliminates your SoR argument.

(Indeed, that is exactly what I have done. I have $150k left on my mortgage and have about that much in cash/medium term bonds to cover it should I ever get the itch to pay it off.)
With yields as low as they are on ST and IT bond funds is it worthwhile keeping the mortgage?
There is value in decreasing sequence of returns risk.

So an accumulator might consider keeping a mortgage even when the risk free rate is lower. Just like a retiree might consider paying off the mortgage even when he might get better returns in something else
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Re: Mortgage Sequence of Returns Risk Example.

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305pelusa wrote: Fri Sep 06, 2019 7:12 am If you pay the mortgage off, you'll end up in the exact same situation as your first scenario. There is sequence of return risk.
Agreed
Watty wrote: Fri Sep 06, 2019 7:01 am The opposite would be if you had $10,000 that you invested all at once and knew that you would keep it invested for 10 years then it would not matter if the one bad year was the first or last year.
The problem with this scenario is that you might plan on living in that house for ten more years but there are lots of reasons that you might decide to move before the ten years is up.

You could also end up being laid off or disabled and your income stream could stop early.
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Re: Mortgage Sequence of Returns Risk Example.

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One other thing to consider is that if not paying off a mortage is a good choice then you would also need to consider things like;

1) Refinancing to take out as much home equity as possible to invest even more.

2) The math for using margin loans in a taxable account to leverage your investments is very similar.

3) Conventional wisdom generally suggests keeping a bond asset allocation of 20, 30, 40 percent or more depending on the details of your situation. Decreasing your bond asset allocation to 0% and being 100% in stocks could make sense using similar math.

There are lots of ways that you can goose your expected long term performance but that almost always comes with the risk that you will get unlucky and and be in the minority where XX% of the time taking additional risk causes a loss.
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Re: Mortgage Sequence of Returns Risk Example.

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Watty wrote: Fri Sep 06, 2019 3:34 pm
The problem with this scenario is that you might plan on living in that house for ten more years but there are lots of reasons that you might decide to move before the ten years is up.

You could also end up being laid off or disabled and your income stream could stop early.
There are many reasons to pay or not pay your mortgage aside from sequence of returns (taxes, job stability, housing preferences, etc).

I thought this particular thread is about the risk of a mortgage in the context of sequence of returns. It doesn't make sense to argue for paying it off due to other reasons.

I could also argue that keeping it is an excellent choice to maintain higher liquidity, or paying it off is an excellent choice in terms of asset protection. But I fail to see how they're relevant to the topic you brought up.
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Re: Mortgage Sequence of Returns Risk Example.

Post by EnjoyIt »

Watty wrote: Fri Sep 06, 2019 3:45 pm One other thing to consider is that if not paying off a mortage is a good choice then you would also need to consider things like;

1) Refinancing to take out as much home equity as possible to invest even more.

2) The math for using margin loans in a taxable account to leverage your investments is very similar.

3) Conventional wisdom generally suggests keeping a bond asset allocation of 20, 30, 40 percent or more depending on the details of your situation. Decreasing your bond asset allocation to 0% and being 100% in stocks could make sense using similar math.

There are lots of ways that you can goose your expected long term performance but that almost always comes with the risk that you will get unlucky and and be in the minority where XX% of the time taking additional risk causes a loss.
As you pointed out in your comment, paying down a mortgage has many moving parts. One good reason to pay down a mortgage early is a cashflow problem. If someone is so riddled in low interest rate debt that they can't afford their lifestyle and their monthly payments, then they need to deleverage significantly. If someone was to make the mistake of buying too much house, it may be in their best interest to sell the home, or pay it down and recast the mortgage to improve their cashflow.

But, to answer your OP title, in the accumulation phase, baring over-leverage, if an investor wants to decrease sequence of return risk, they should keep the mortgage and invest the difference.

To answer your other question regarding time. If one was to move within a couple of years, they would be buying another house and likely taking on another mortgage which is why looking at the problem over 5 years is also a mistake. We need to consider it over the life of all possible mortgages as well as what happens in the decades during retirement. We also need to consider as monthly payments and not necessarily a lump sump decision which is what most people do when they acquire a mortgage and are looking to see if they should pay it down faster or not.

Listen, if you have $2.5 million and want to pay off a low interest rate $100k mortgage, it may make some sense to just get it over with despite the potential loss in arbitrage revenue. If you have no wealth and you are looking to pay down a 30 year mortgage over 5 years instead of investing, you are taking significant risk. Everything else is in between.
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